Tax planning and compliance for investors
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By Kaye A. Thomas
Posted January 15, 2010
A mistake, but a correctable one.
Interest in Roth conversions has heated up with the recently liberalized rules. Millions of taxpayers who were previously ineligible to convert a traditional IRA to a Roth are now able to do so — and potentially able to make mistakes on those conversions.
One such mistake would be to do a conversion in a year for which the account owner has to take a required minimum distribution, or RMD, before taking that distribution. This is not allowed, and some people worry that the results could be disastrous. In reality it's a correctable mistake, and even with a failure to make a timely correction it's something less than a disaster.
Owners of traditional IRAs aren't allowed to leave all the money in the account indefinitely. To encourage people to use these accounts for retirement purposes rather than estate planning purposes, the tax law requires owners to take minimum distributions each year, beginning with the year they turn 70½. (The distribution for the first year can be postponed until April 1 of the following year, but all others must be taken in the year to which they relate.) Congress wanted to be absolutely certain these amounts would be paid out of the retirement accounts, so the penalty for failing to do so is highly punitive: 50% of the amount that should have been distributed.
Owners had a reprieve from the RMD rule for 2009 due to a one-time relief measure adopted because of the economic meltdown, but the rule is reinstated as of 2010.
People receiving required minimum distributions aren't allowed to roll them over to another IRA or retirement plan — and that means they aren't allowed to convert these payments to a Roth IRA. What's more, the IRS says the first dollars that come out of a traditional IRA in a year for which the RMD rule applies must be treated as RMD dollars. In effect, they are saying you have to satisfy the RMD requirement before you do a Roth conversion. The requirement won't apply for subsequent years because Roth IRA owners (other than nonspouse beneficiaries) are not required to take RMDs.
Generally speaking the best time of year to do a Roth conversion is early in the year, because this choice affords you the longest lookback period until you have to decide whether to use a recharacterization to undo the conversion. And it's generally best to take required minimum distributions late in the year, because this choice allows you to keep money in your IRA for a longer period of time. Someone who follows both of these approaches, and fails to connect with the rule requiring RMDs to come out before a Roth conversion, could blunder into a violation of this rule.
It might seem that the onerous 50% penalty on failure to take a required minimum distribution would apply in this situation. Yet the tax regulations make it clear that this is not the case. (See Reg. section 1.408A-4, Q/A 6.) The first dollars out of the traditional IRA are considered to be RMD dollars. This rule will apply even if the dollars came out of the IRA as part of a Roth conversion. In fact, the rule applies even if the conversion was accomplished by redesignating the traditional IRA as a Roth, despite the fact that no dollars actually moved out of the IRA, because in that case you're treated the same as if you took dollars out of the traditional IRA and transferred them to a new Roth IRA. This means you've automatically satisfied the RMD requirement when you did the Roth conversion.
You most likely still have a problem, of course, but it's an easier one to correct. You've transferred to the Roth IRA some dollars that weren't eligible for rollover. These dollars are now treated as a regular contribution to the Roth, not a rollover contribution. This could be no problem at all if you happen to qualify for a regular Roth contribution in this amount, and in this case you can leave the money in the Roth.
Most people taking RMDs aren't able to make regular contributions to IRAs, though, because they're over 70½ and often don't have compensation income, which is a requirement for IRA contributions. In this case, the RMD money that went into the Roth would be an excess contribution. Failure to correct this problem would result in the 6% excess contribution penalty, which applies to the year of the contribution and to each subsequent year until the excess is corrected. Most people should be able to discover the problem before the time expires to make a corrective distribution for the year of the conversion (which must be made by October 15 of the following year). And for those who discover the problem too late, it's still a lot better to pay the 6% excess contribution penalty for a year or two than to pony up the 50% RMD penalty.
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